Bad Debt Expense Journal Entry, Methods & Examples

Sometimes, people Keep Records for Small Business encounter hardships and are unable to meet their payment obligations, in which case they default. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License . The allowance method is the more generally accepted method due to the direct write-off method’s limitations. Some industries or regulatory frameworks may require or favor the Direct Write-Off Method. In such cases, businesses benefit from compliance without the need for additional reconciliation processes. Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting.

THE DIRECT WRITE OFF METHOD

When considering the direct write-off method for handling bad debt, businesses must weigh the simplicity of the approach against the potential impact on financial reporting and tax implications. This method, which involves writing off bad debts only when they become certain that the debt is uncollectible, can be appealing for its straightforwardness. However, it may not always align with the accrual accounting principles, which require expenses to be matched with related revenues. This entry reflects the removal of the uncollectible amount from accounts receivable and records it as an expense.

• Bad debt expense is the loss that incurs from the uncollectible accounts where the customers did not pay the amount owed.
• Imagine a small electronics store, Tech Haven, that sells products on credit.
• For example, a category might consist of accounts receivable that is 0–30 days past due and is assigned an uncollectible percentage of 6%.
• This estimated amount is then debited from the account Bad Debts Expense and credited to a contra account called Allowance for Doubtful Accounts, according to the Houston Chronicle.

Percentage of Receivables

However, critics argue that it fails to match expenses with revenues in the period they are incurred, which is a core principle of accrual accounting. The last method of bad debts estimation is the aging of receivables method. This is by far the most sophisticated because it doesn’t rely on a single uncollectibility rate—unlike the two others.

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Eric Gerard Ruiz, a licensed CPA in the Philippines, specializes in financial accounting and reporting (IFRS), managerial accounting, and cost accounting. He has tested and review accounting software like QuickBooks and Xero, along with other small business tools. Eric also creates free accounting resources, including manuals, spreadsheet trackers, and templates, to support small business owners. Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping.

• Timing plays a significant role in this method, as the expense is recorded only upon confirmation of non-payment.
• Part of the cost of allowing customers to borrow money, which is essentially what a customer is doing when the business allows the customer time to pay, is the expense related to uncollectible receivables.
• The allowance method adheres to the GAAP and reports estimates of bad debt expenses within the same period as sales.
• This method uses estimations since the company is still unsure which customer accounts will be worthless.
• If you’re wondering which method is best for your small business, speak with a professional for insights into your specific situation.

At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net Accounts Receivable. Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific accounts receivable assigned to a customer. Because it is an estimation, it means the exact account that is (or will become) uncollectible is not yet known. For example, a customer takes out a $15,000 car loan on August 1, 2018 and is expected to pay the amount in full before December 1, 2018. For the sake of this example, assume that there was no interest charged to the buyer because of the short-term nature or life of the loan.

• We cannot debit bad debt because we have already recorded bad debt to cover the percentage of sales that would go bad, including this sale.
• Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License .
• Companies that follow GAAP should use bad debt allowances to recognize bad debts.
• The contra-asset, Allowance for Doubtful Accounts, is proportional to the balance in the corresponding asset, Accounts Receivable.
• The sale occurred December 1st 2015 and has payment due in 60days, so at year end December 31st 2015 the account is not yet due.

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Either net sales or credit sales method is acceptable in the calculation of bad debt expense. However, if the credit sales fluctuate a lot from one period to another, using the net sales method to calculate bad debt expense may not be as accurate as using credit sales. However, if the company doesn’t focus on credit sales and only made a few credit sales during the year with only a small balance of receivables, they may use the direct write off method in calculation of bad debt expense. Then all of the category estimates are added together to get one total estimated uncollectible balance for the period.

Unlike other methods that estimate bad debts, the direct Write-Off method records bad debt expenses only when a company determines an account to be uncollectible. This method is direct write-off method straightforward because it allows businesses to deal with actual losses rather than anticipated ones. The allowance method creates bad debt expense before the company knows specifically which customers will not pay. Based on prior history, the company knows the approximate percentage or sales or outstanding receivables that will not be collected.

Accounts Receivable Ratios

• This consistency can be beneficial for stakeholders, such as investors and creditors, seeking to evaluate a company’s operational efficiency and predict future cash flows.
• Bad debt expense is the loss that incurs from the uncollectible accounts, in which the company made the sale on credit but the customers didn’t pay the overdue debt.
• Inevitably some of the amounts due will not be paid and the business will need to have a process in place to record these bad debts.
• In January, it makes a sale of $10,000, expecting to receive the payment within 30 days.
• For example, in one accounting period, a company can experience large increases in their receivables account.
• Let’s look at a sample where the company uses the percentage of receivables method in determining bad debts.

From a tax perspective, the direct write-off method can be less favorable for businesses. This is because tax authorities, like the IRS in the United States, typically require the use of the allowance method for financial reporting purposes. The allowance method estimates bad debt expenses at the end of each accounting period, which can create a discrepancy between book and tax reporting. The percentage of receivables method is a balance sheet approach, in which the company estimate how much percentage of receivables will be bad debt and uncollectible.

Company

Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled $324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period. BWW estimates 15% of its overall accounts receivable will result in bad debt. The final point relates contra asset account to companies with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit to its customers.